Cost of Revenue

Definition of Cost of Revenue

The term “cost of revenue” (COR) refers to the total cost incurred toward a company’s production and distribution of products and services. In other words, any costs that can be directly attributed to the production and distribution of goods and services are captured under the COR. It is quite similar to costs of goods sold (COGS), but it also includes distribution and marketing expenses as well as other directly attributable expenses.

Explanation of Cost of Revenue

The COR of a company can be found in its income statement as it is intended to capture all the direct costs that can be linked to the goods manufactured or the services provided by the company. However, the cost of revenue may vary from one company to another as the costs head included under the COR varies depending on the industry in which the company operates.

Formula for Cost of Revenue

The COR formula can represent the summation of direct material, direct labor, distribution costs, marketing costs, and other directly attributable costs. Mathematically, it is represented as shown below.

How to Calculate Cost of Revenue?

The below mentioned steps are to be followed for calculating the COR:

• Step 1: Firstly, determine the direct cost of material, which includes raw material consumption and a change in inventory towards work in process products.
• Step 2: Next, determine the direct cost of labor, which includes the cost of manpower engaged in the production.
• Step 3: Next, determine the distribution costs, which include expenses incurred to deliver the product at the customer’s place.
• Step 4: Next, determine the marketing costs, which include advertising and agency fees incurred for promoting the product.
• Step 5: Next, determine all other directly attributable costs that were not included in the above-mentioned cost heads.
• Step 6: Finally, the formula for COR can be derived by adding direct material (step 1), direct labor (step 2), distribution costs (step 3), marketing costs (step 4), and other directly attributable costs (step 5)as shown below.

Cost of Revenue = Direct Material + Direct Labor + Distribution Costs + Marketing Costs + Other Directly Attributable Costs

Examples

Following are examples as given below:

Example #1

Let us take the example of a company to illustrate the concept of COR. The company is engaged in the production of soft drinks in the state of Illinois. The following information is available for the year 2019:

• Direct material = $20 million
• Direct labor = $10 million
• Distribution costs = $2million
• Marketing costs = $4 million
• Other directly attributable costs = $1 million

Determine the COR of the company for the year 2019 based on the given information.

Solution:

COR is calculated as:

Cost of Revenue = Direct Material + Direct Labor + Distribution Costs + Marketing Costs + Other Directly Attributable Costs

• COR = $20 million + $10 million + $2 million + $4 million + $1 million
• COR = $37 million

Therefore, the company incurred a cost of revenue of $37 million during the year 2019.

Example #2

Let us use SDF Inc.’s example to demonstrate which expenses should be considered under the COR. The company is a manufacturer of solar lamps and operates in the state of Missouri. Determine the cost of revenue of the company for the year 2019 on the basis of the information provided below:

• Direct material = $50 million
• Salary paid to managers = $9 million
• Direct labor = $20 million
• Research & development expenses = $4 million
• Distribution costs = $5 million
• Administration costs = $10 million
• Marketing costs = $8 million
• Other directly attributable costs = $2 million

Solution:

In this case, salary paid to managers, research & development expenses, and administration costs won’t be considered in the calculation of the COR as these costs are indirect in nature, i.e. can’t be directly attributed to the production process.

Now, the COR for the company can be calculated by using the above formula,

Cost of Revenue is calculated as

Cost of Revenue = Direct Material + Direct Labor + Distribution Costs + Marketing Costs + Other Directly Attributable Costs

• COR = $50 million + $20 million + $5 million + $8 million + $2 million
• COR = $85 million

Therefore, SDF Inc. incurred a cost of revenue of $85 million during the year 2019.

Importance of Cost of Revenue

From the perspective of cost, the cost of revenue is a very important concept as it reveals the entire input cost of production during a given period of time. It provides a clear break-up of the direct and indirect costs involved in the production that can be a crucial input for management decision-making. In fact, most companies analyze the cost of revenue and use it to optimize their operations by eliminating the excess costs incurred during the production process.

Benefits

• It can be used to strike the optimal mix of the direct and indirect cost of production.
• It is helpful in the identification of sudden changes in the cost structure.

Disadvantages

• There is some level of subjectivity about the cost heads that goes into the calculation of the cost of revenue, which impedes standardization.
• The accountants and managers can manipulate the COR for their own vested interests.

Conclusion

So, it can be seen that cost of revenue is a crucial factor in the analysis of a company’s cost structure as well as profitability. However, it should be noted that its components may vary depending on the industry and nature of operations.

Recommended Articles

This is a guide to Cost of Revenue. Here we discuss the introduction and cost of preferred stock financing along with its benefits and importance. You may also have a look at the following articles to learn more –

1. Incurred Cost
2. Revenue Reserve
3. Fixed Cost
4. Revenue Streams